Thursday, March 4, 2010

Some Alternatives to Foot-Dragging on Financial Reform

It’s the hardest thing to understand about the U.S. economy: why there hasn’t yet been any serious attention paid to the problems of the financial system and the changes needed in the rules it operates under. It’s not that there hasn’t been time. Many people saw the need for reforms in 2005. By 2006, the need for change had become so obvious that bills in the House of Representatives were referred to committee for study. And the financial system’s troubles and shortcomings have only become more obvious in the years since. Yet the simplest reforms have not yet been made.

Lawrence Lessig wrote today that the problem is “Systemic Denial” — at a conference yesterday, “Expert after expert spoke as if the problems we faced were simple math errors” rather than the more serious errors we see in business models, management, government oversight, and ultimately, governance.

The consensus of experts seems to agree with the White House line that we have stepped back from the precipice, when a more accurate depiction would be that we have dropped some rocks over the edge, and are a in position to drop more and perhaps fall over the edge ourselves.

A big part of the problem comes from taking the financial infrastructure for granted. Few, if any, of our great financial institutions are run by people who understand how they work. Worse, government regulators and investors seem to think this state of affairs is acceptable. Perhaps in calmer times it might be tolerable, but at this point, the risk it poses to the economy is enormous.

No expertise is required to be a bank CEO, but that doesn’t excuse bank executives from being held accountable for the mistakes they make. Regulators have forced out perhaps 20 bank executives in the past two years for having a pattern of making stupid mistakes that put their banks at risk, but in most of those cases, there were issues of corruption involved as well — and in most of those cases, the banks in question failed, or are well on their way to doing so.

So that is the right idea, but it is not nearly enough. Boards of directors should be removing executives who have a pattern of mistakes of incompetence. In some cases, where the actions are not mere mistakes, prosecutors should be taking action. Stockholders should be removing directors who don’t understand the businesses they are overseeing.

Alas, very little of this is realistically going to occur. And so the risk remains great. The only realistic prospect for protecting the economy is to keep institutional power from becoming too large — and roughly fifty large financial institutions are already too large.

A set of strict break-up-the-banks rules would create too much concentrated power in the hands of the politicians and bureaucrats who would design and implement the rules. I don’t want to see that happen, but I also don’t want to see rules so flexible that Wall Street can find a way around them. That still gives us plenty of options, though. These are the kinds of rules that I think would address the problem of institutions that have become too large:

  • A merger tax. There could be a very simple tax, perhaps 1/2 percent of assets, on both corporations involved in any corporate merger or buyout. This tax would have to be paid before any merger could be finalized. This tax, obviously, would discourage very large companies from merging into still larger companies, but it would fall less heavily on smaller companies.
  • A tax on leveraged buyouts. Leveraged buyouts have set up many of the spectacular bankruptcies of the last three years. There ought to be a tax that reflects the costs of those bankruptcies and, in addition, some of the economic costs that result from the concentration of power found in the resulting corporations. I would suggest a tax of 20 percent on all money borrowed for any corporate buyout. To avoid loopholes, this tax would also have to apply to advisory, management, transaction, and other fees associated with the leveraged buyout. I realize that Wall Street, which is used to not paying taxes, will think this an extraordinarily stiff tax. I would remind them that the personal income tax rate is higher than this.
  • Higher reserve requirements for large banks. There is no mistaking the tendency of the largest banks to be involved in casino-style activities that put the banking system as a whole at risk. That tendency has increased markedly since 2008 because of the financial pressure on these banks. To compensate for this risk, I would suggest that for any bank holding company whose total assets are greater than 1 percent of the country’s total insured deposits, the reserve requirement ought to be based on total assets, rather than on deposits. Further, to the extent that the assets are greater than this threshold, the reserve requirement rate should be doubled. This allows banks to be extraordinarily large if there is a compelling business reason for them to do so, but it prevents the large banks from ruining the whole banking system by taking everyday banking business away from the real banks.

Changes such as these wouldn’t cause any undue hardships, and if phased in over two or three years, they wouldn’t require any uncomfortable adjustments. Yet they could go as far as we need to go toward reducing the threat posed by a top-heavy financial system.

Finally, as always, I have to mention the urgent need to make derivative contracts public. No one can make the claim that we are getting a handle on the problems of the financial system — indeed, we do not even know the scale or character of the problems we face — as long as derivatives are allowed to be traded in secret.